Can You Cash In a Life Insurance Policy Before Death?

Life insurance policies primarily provide financial protection to beneficiaries after the insured’s passing. However, certain types of life insurance allow policyholders to access accumulated funds during their lifetime. This feature enables individuals to utilize a portion of their policy’s value under specific conditions, offering a potential financial resource. This article explores the different avenues available for accessing value from a life insurance policy prior to the insured’s death, outlining the processes and implications of each method.

Understanding Policy Cash Value

Cash value in a life insurance policy is a savings component within certain types of permanent life insurance. Unlike term life, which provides coverage for a specific period and does not build cash value, permanent policies (whole life, universal life, variable universal life) include this feature. A portion of each premium contributes to this cash value, which grows tax-deferred; earnings are not taxed until withdrawn.

Cash value is distinct from the death benefit. The death benefit is paid to beneficiaries upon the insured’s death, while cash value is a living benefit accessible during the policyholder’s lifetime. As cash value grows, it provides a financial resource. If the policyholder passes away, any remaining cash value is typically retained by the insurance company unless policy terms or riders dictate otherwise.

Cash value accumulation rates vary by permanent policy type. Whole life policies offer guaranteed growth at a fixed interest rate. Universal life policies tie growth to current interest rates or an external index. Variable universal life policies allow investment in various sub-accounts. In early policy years, more premiums may be allocated to cash value, gradually decreasing as insurance cost increases with age.

Accessing Policy Cash Value Through Surrender or Loans

Policyholders can access cash value within their permanent life insurance policies through two methods: surrendering the policy or taking a policy loan. Each option carries distinct financial and tax implications. Understanding these differences is important for informed decisions.

Policy Surrender

Policy surrender terminates the life insurance contract for its cash surrender value. To initiate, the policyholder contacts the insurer and completes a surrender request, often providing the original policy and identification. Once processed, the insurer pays out the cash surrender value, usually as a lump sum.

The cash surrender value is the accumulated cash value minus any surrender charges and outstanding policy loans. Surrender charges are fees insurers may impose, particularly in early policy years, to recoup initial expenses. These charges decrease and may disappear after 10 to 15 years.

Surrendering a policy ceases the death benefit; beneficiaries receive no payout. Tax-wise, if cash surrender value exceeds total premiums paid (the “cost basis”), the excess is generally taxable ordinary income by the IRS.

Policy Loan

Policy loans allow policyholders to borrow money directly from the insurance company, using the policy’s cash value as collateral. The loan is from the insurer’s general account, and the policy remains in force. Policyholders can borrow up to 90% or 95% of the accumulated cash value.

Obtaining a policy loan is straightforward, often involving a simple request. Unlike traditional bank loans, policy loans do not require credit checks and offer flexible repayment terms, with no mandatory schedule. Interest rates range from 5% to 8%.

Loan proceeds are generally tax-free as long as the policy remains in force, but interest accrues on the outstanding balance. Unpaid loans and interest reduce the death benefit. If the loan balance plus interest exceeds the cash value, the policy can lapse, potentially making the outstanding loan taxable. Repaying the loan restores cash value and the full death benefit.

Selling Your Policy for Cash

A life settlement is a third-party transaction: the sale of an existing life insurance policy to a life settlement provider or investor for a cash sum. This payout exceeds the policy’s cash surrender value but is less than its full death benefit. Policyholders consider a life settlement when they no longer need coverage, cannot afford premiums, or require funds.

The process begins with the policyholder contacting a provider or broker for eligibility and appraisal. Eligibility requires the policyholder to be at least 65 years old, though younger individuals with significant health impairments may also qualify. The policy should have a death benefit of $100,000 or more and be a permanent type. The provider requests medical records and policy information to assess life expectancy, a factor in the offer.

Once an offer is negotiated and accepted, the policyholder signs documents transferring ownership to the buyer. The buyer becomes the new policy owner and beneficiary, assuming responsibility for all future premium payments. The original policyholder receives a lump-sum cash payment, relinquishing all rights to the policy and its death benefit.

Life settlement proceeds have specific tax implications. The IRS generally applies a three-tiered tax structure. First, the portion of proceeds equal to the policyholder’s “cost basis” (total premiums paid) is tax-free. Second, any amount received above the cost basis, up to the policy’s cash surrender value, is taxed as ordinary income. Finally, any proceeds exceeding the cash surrender value are taxed as a capital gain. Consult a tax professional for precise tax liability.

Accessing Benefits for Terminal or Chronic Illness

Life insurance policies offer financial support during severe health challenges through provisions for terminal or chronic illnesses. These options allow policyholders to access a portion of their death benefit while alive, providing funds for medical expenses, care, or to improve quality of life. Terms and availability depend on the policy.

Accelerated Death Benefits (Living Benefits Riders)

Accelerated Death Benefits (ADBs), often called “living benefits riders,” allow a policyholder to receive a portion of their death benefit if diagnosed with a qualifying illness. Triggers include terminal illness (life expectancy of 24 months or less), chronic illness (inability to perform at least two of six activities of daily living), or critical illness (e.g., heart attack, stroke, or cancer). The policyholder must provide medical documentation to the insurer for eligibility.

Funds received from an ADB are deducted from the policy’s death benefit, reducing the amount paid to beneficiaries. For example, if a policy has a $500,000 death benefit and $100,000 is accessed via an ADB, beneficiaries receive $400,000. ADBs received by terminally or chronically ill individuals are generally tax-free under federal law, provided specific IRS guidelines are met, such as using funds for qualified long-term care expenses.

Viatical Settlements

A viatical settlement is a specific type of life settlement for policyholders with a terminal or chronic illness, often with a life expectancy of two years or less. Similar to a standard life settlement, it involves selling the life insurance policy to a third party for a lump sum cash payment. This payment exceeds the cash surrender value but is less than the full death benefit.

The distinction from a general life settlement is the policyholder’s health status and favorable tax treatment. Proceeds are generally not subject to federal income tax if the insured is certified as terminally ill (life expectancy of 24 months or less) or chronically ill and funds are used for qualified long-term care expenses. The buyer assumes future premium payments and receives the death benefit upon the insured’s passing. This option provides immediate financial liquidity for individuals facing severe illness.